A tech bubble is the rapid inflation in the valuation of public and private technology companies that exceeds their fundamental value by a large margin. It is accompanied by the rationalisation of the new pricing, and then followed by a spectacular crash in value. (It also has the “smart money” investing early and taking profits before the crash.)

Bubbles are not new; we have had them for hundreds of years (the Tulip Mania, South Sea Company, Mississippi Company, etc.). And in the last decade, we have had the dot.com bust and the housing bubble. This tech bubble is unfolding just like all the other bubbles before it.

Today, the signs of the new bubble are the Linked-In initial public offering (IPO), Facebook’s stratospheric valuation and the rapid rise of early-stage startup valuation. Hiring technology talent in Silicon Valley is getting difficult, and the time it takes to drive across Palo Alto has tripled—all signs of the impending apocalypse.

Dr Jean-Paul Rodrigue, in the Department of Global Studies & Geography at Hofstra University, observed that bubbles have four phases; stealth, awareness, mania and blow-off. I contend that we are approaching the early part of the mania phase.

In the stealth phase, prescient angel investors and Venture Capitalists (VCs) start investing in an industry or market segment that others have not yet found. In the case of this bubble, it was social networks, consumer and mobile applications, and the cloud. VCs who understood the ubiquity, pervasiveness and ultimate profitability of these startups doubled-down on their investments. Long before others, they saw that these applications could have hundreds of millions of users with “off the chart” revenue and profits.

The awareness phase is where other later-stage investors start to notice the momentum, bringing additional money in and pushing prices higher. The Russian investment group, DST, is an example, with their $200 million investment in Facebook, at a $10 billion valuation, in 2009. This was followed by another $500 million investment (along with Goldman Sachs) in 2011, at a $50 billion valuation. Meanwhile, the bubble for “seed stage” startups began when Ron Conway’s Silicon Valley Angels and DST guaranteed every startup out of a YCombinator $150,000. And it was hammered home with Color—a startup without a product—raising $40 million, at a reputed $100 million valuation, from brand name VCs who should have known better. When they did launch their product, it was compared to boo.com, and entered the dot.com bubble hall of infamy. Meanwhile, smart VCs continue to invest in this segment and increase their ownership of existing companies. The technology blogs (TechCrunch, et al.) start cheerleading, and the general business press/blogs start paying attention. And all of the investors trot out explanations of “why—this time—everything is different”.

We have just entered the maniaphase. The Linked-in IPO valued the company at $8.9 billion at the end of the first day of trading. It sent a signal that there is an irrational demand for tech IPOs. Silicon Valley startups are falling over each other to file their S-1 documents to go public.

Some precursors to the bubble happened when Chinese Internet companies listed on United States stock exchanges. In December 2010, Youku—the YouTube of China—went public, with a valuation of $4.4 billion at the end of the first day (on $58.9 million in 2010 sales). In May 2011, RenRen—the Facebook of China—had a first day valuation of $7.4 billion (on $76.5 million in 2010 sales).

Dr Rodrigue’s description of what happens next sounds familiar: “the public jumps in for this ‘investment opportunity of a lifetime’. The expectation of future appreciation becomes a ‘no brainer’…Floods of money come in creating even greater expectations and pushing prices to stratospheric levels. The higher the price, the more investments pour in. Unnoticed from the general public, the smart money as well as many institutional investors are quietly pulling out and selling their assets…Unbiased opinion about the fundamentals becomes increasingly difficult to find as many players are heavily invested and have every interest to keep asset inflation going.”

“The market gradually becomes more exuberant as ‘paper fortunes’ are made and greed sets in. Everyone tries to jump in and new investors have absolutely no understanding of the market, its dynamic and fundamentals…statements are made about entirely new fundamentals implying that a ‘permanent high plateau’ has been reached to justify future price increases.”

We are seeing this bubble unfold by the book.

No one doubts that social networks and web and mobile applications are reinventing commerce. Obviously, some of these companies will have hundreds of millions of customers, unprecedented revenue growth and great profits. Yet none of these companies have earned the valuations that they are receiving.

The greater fool theory. Even those aware of the silliness participate because they believe someone else is a true believer and will pay them an even more inflated price. Eventually, there is no one left who truly believes, and those betting on a greater fool coming around are left holding the bag.

Stare long and hard at that sharp climb before the equally sharp fall.

You can make a fantastic amount of money by investing in bubbles; just because there’s no underlying increase in value doesn’t make your piles of money any less real (assuming you cash out before the crash). You’d be a fool /not/ to invest in a bubble–

It happens in every bubble. People ARE irrational, everyone. When people see other people “making” lots of money doing nothing they start to “feel” that maybe other people is right after all and he is wrong.

Do you thing Newton was smart? He bought stock of the the “South Sea Company”, one of the first financial scams and sell at like 4 times what he had invested when he thought is was not going to rise more.

But it rose, more and more,he saw all his friends get “rich” one after another, so Newton “reinvested”(or gambled) his money again and the bubble flop, and said:
“I can calculate the motions of heavenly bodies, but not the madness of people.”

I live in Spain, here home prices were rising >25% each year, in some places doubling it. I KNEW it was a classical bubble because I read economic books but as time went by and the prices went higher and higher and people started to say that “home prices never had went down on history”, and “prices never will go down as the German people will buy”, I saw people “buying”(getting a loan) for 60.000 and sell two years later for 150.000!!! without working at all.

I started to believe that maybe I was wrong because I said: it has to go down and it went up again and again. Everybody left and right were telling me how good opportunities houses were. I started feeling outside of the groups as they did not liked what I had to say. They wanted to believe because everybody had bought houses(young people for their selfs and old people helping their offspring or investment.

After watching a news report of potential buyers camping out overnight, I called the housing bubble back in 2002 and watched in horror as fraud brought it to atmosphereic heights. I correctly predicted the timing of the collapse as well. No one would listen. I was called a crackpot, crazy, ‘renting is throwing your money away’ – one person even accused me of being jealous because I wasn’t getting rich too! After they were foreclosed on, lost their shirts, or are still paying mortgages on property worth half what they owe, now they don’t want to discuss it at all…except when I overhear them claim ‘Well, no one could have predicted it…’

[…] Steve Blank and Ben Horowitz debate the issue in the Economist. Big IPOs, big early stage valuations, tight labor in Silicon Valley point toward yes, but if the valuations are still anchored to reality, that points to no. It’s good that the question is getting asked and talked about this time around. […]

Even amongst those that recognize the bubble, the incentive is to stay in and keep dancing because the profits go exponential and they’re convinced that they can be the first out the door once the flames get out of control.

That is as good a picture as any of the sequence of events, but the background image of ‘smart money, institutional investors, public’ is contrived. It is institutional investors, led by college endowments and public pensions, that fuel this insanity of greed. There is no ‘sell off’ bump as depicted.

More importantly, the belief that 2+2=5 fuels both the government power structure and the privileges of the endowments. There is no such thing as ‘smart money,’ just as there is no such thing as a ‘smart bomb.’ Wisdom is in the hands of the person who holds it, or not.

Pandora is a perfect example. It has a 3 billion dollar IPO and the company is losing money. A company that has never made money shouldn’t have a valuation that large. It just doesn’t make sense.

The question that I’ve been wondering about is if we are in a tech bubble and the market crashes what will its side effects be? Is there something that someone could bet on (invest in) that would go up if the tech market crashes? If anyone has any stories from the previous bubble I’d be interested.

It doesn’t feel like we’re there yet, as I default back to the mom rule. When your mom mentions the latest tech ipo, or when your mom talks about buying and flipping houses… then you know you’re in a bubble.

You should take a look at Carlotta Perez’s “Technological Revolutions and Financial Capital: The Dynamics of Bubbles and Golden Ages.” She is a “neo-Schumpterian” who would argue we have another two decades at least to recover from 1999 before we see another bubble. There is quite a bit more to her book than I am able to summarize here, it’s on Amazon at http://www.amazon.com/Technological-Revolutions-Financial-Capital-Dynamics/dp/1840649224/

Thank you for this article – the topic was also touched on by this morning’s “Today” programme on BBC Radio 4. As I was half-asleep at the time this post has proven helpful. I would guess that you are right about the current “phase” but I wouldn’t want to bet on the precise timing of it.

Bubbles Occur Even with the knowledge of the bubble happening because of greed. The Big Banks can keep pushing money into a bubble until it just looks too good to not get a piece of it then once enough people buy in the big banks bail out and leave you with the losses.

While it unfolds “by the book,” is the time between the “bear trap” and the “bull trap” getting shorter with each passing bubble? Kind of like when you boil water and the bubbles form and pop faster as the pot gains heat.

Steve, congrats on winning the debate! The parallels to the last bubble couldn’t be clearer, even the selection of Mr. Horowitz as an “unbiasied” opponent has precedence in the bubble of 12 years ago. I outlined that and 8 other parallels on my blog